Chapter 22 The Residential Mortgage Market

McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.  Learning Objectives  To understand how the residential mortgage market supplies credit for individuals and families to build and buy homes. To understand the problems faced by lenders in designing new home loan contracts that will protect them against inflation and other risks.

McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.  Learning Objectives  To look at how federal government agencies and government- sponsored mortgage firms support the development of the market for mortgage loans.

McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Introduction Among the fastest growing of all financial markets today is the residential mortgage market, where individuals and families fund their purchases of homes. Originally a simple market that was primarily local and regional in character, the residential mortgage market has become an international capital market where home-mortgage-related instruments are traded around the globe.

McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Recent Trends in New Home Prices and the Terms of Mortgage Loans Prices and Yields of Conventional Home Mortgage Loans

McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Recent Trends in New Home Prices and the Terms of Mortgage Loans Offsetting the relatively low home-mortgage loan rates of recent years have been record-high home prices. Overall, real home prices have risen considerably faster than homeowner incomes, discouraging some potential home buyers.

McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. The Structure of the Mortgage Market

McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. The Structure of the Mortgage Market Mortgage Loans Outstanding, 2004* ($ Billions)

McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Mortgage Lending Institutions

McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Mortgage Lending Institutions Most mortgages generate multiple potential cash-flow streams: -origination & commitment fees (when a mortgage loan is first applied for) -periodic loan repayments & loan interest -compensation for prepayment & default risks -service fees associated with collecting & recording amounts owed -net returns & fees from the securitization of a pool of mortgage loans

McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Mortgage Lending Institutions A mortgage loan may be -held in the originating lender’s portfolio for the promised interest and principal payments; -sold to an investor at a discounted value (although the originating lender may retain servicing rights and charge the loan purchaser loan servicing fees); or -packaged with other similar mortgage loans into a pool and securitized (the lender receives residual interest income and servicing fees).

McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. The Roles Played by Leading Financial Institutions in the Mortgage Market Savings and loan associations (S&Ls) are predominantly local lenders. They often service the mortgage loans they made. Commercial banks rank first as lenders for the purchase of homes, condominiums, and apartments, and in the commercial mortgage sector. Savings banks invest in both government-guaranteed and conventional mortgage loans.

McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. The Roles Played by Leading Financial Institutions in the Mortgage Market Life insurance companies make substantial investments in commercial as well as residential mortgage properties, both nationally and internationally. Mortgage banking houses act as a channel through which builders or contractors in need of long-term funds can find permanent mortgage financing.

McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Government Activity in the Mortgage Market The Great Depression generated massive, unprecedented unemployment, such that property values fell, thousands of foreclosures occurred, and many mortgage lenders faced liquidity crises. So, the U.S. federal government had to move in to tackle the mortgage market’s problems, through government guarantees and the development of a secondary market.

McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Government Activity in the Mortgage Market The major milestones include: -1932: Federal Home Loan Bank System -1934: National Housing Act, Federal Housing Administration -1938: Federal National Mortgage Association (Fannie Mae) -1944: Servicemen’s Readjustment Act, Veterans Administration

McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Government Activity in the Mortgage Market -1968: Government National Mortgage Association (Ginnie Mae) (Its pass-throughs are popular with investors as safe, readily marketable securities with attractive rates of return.) -1970: Federal Home Loan Mortgage Corporation (Freddie Mac) (Its mortgage-backed securities include mortgage participation certificates (PCs), guaranteed mortgage certificates (GMCs), collateralized mortgage obligations (CMOs), and real estate mortgage investment conduits (REMICs).)

McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Government Activity in the Mortgage Market The development of various types of securitized mortgages have made mortgage securities more competitive with government and corporate securities, allowing many mortgage lenders to invade the national and international capital markets for funds. However, these new financial instruments have also increased the sensitivity of mortgage interest rates to national and international market conditions.

McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Innovations in Mortgage Instruments The problems created by fixed-rate mortgages (FRMs) led to the development of variable-rate mortgages (VRMs) and adjustable mortgage instruments (AMIs). Volatile interest rates also led to the development of convertible mortgage instruments (CMIs), balloon loans and hybrid mortgages.

McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Innovations in Mortgage Instruments Interest-only mortgages offer borrowers the option of only paying the interest on their home mortgages, without retiring loan principal, for an initial time period. Reverse-annuity mortgages (RAMs) have also been developed to help older families.

McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Innovations in Mortgage Instruments It is interesting that, with all the new mortgage instruments developed in recent years, fixed-rate mortgages (FRMs) continue to hold a major share of the residential loan market.

McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Pricing and Other Issues in Home Mortgage Lending A key reference interest rate that many mortgage lenders use to determine the appropriate loan rate on new home loans is the 10-year U.S. Treasury bond rate. A comparison of recent 10-year T-bond yields to home mortgage contract rates indicates that mortgage rates move closely with T-bond rates and maintain a yield spread of about 1.6 to 2 percentage points between them.

McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Pricing and Other Issues in Home Mortgage Lending Comparison of Home Mortgage Interest Rates and the Annual Yields on Ten-Year U.S. Treasury Bonds

McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Mortgage Lock-Ins, Loan Modifications, and Foreclosures Mortgage lock-ins protect borrowers from an increase in loan rates during the house-buying process, while loan modification agreements aid troubled borrowers in avoiding foreclosure.

McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Refinancing Home Mortgages In recent years, as market interest rates fell and house values increase, many homeowners have chosen to refinance their home mortgages. The ability of a homeowner to obtain refinancing depends critically upon a strong credit history and a significant amount of accumulated equity built up in the home to be refinanced.

McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Predatory Lending Allegedly, some unscrupulous lenders attempt to mislead poorly informed, less well-educated borrowers into taking out high-cost loans, often with their home pledged as collateral. The current debate on such predatory loans centers mainly on how to distinguish predatory from legitimate lending practices and how to protect the most vulnerable consumers.

McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Markets on the Net A Consumer’s Guide to Mortgage Lock-ins at Federal Deposit Insurance Corporation at Federal Home Loan Mortgage Corporation at Federal National Mortgage Association at

McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Markets on the Net Government National Mortgage Association at Interest Rate Calculator at Mortgage Bankers Association of America at

McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Chapter Review Introduction to the Residential Mortgage Market Recent Trends in New Home Prices and the Terms of Mortgage Loans The Structure of the Mortgage Market -Volume of Mortgage Loans -Residential versus Nonresidential Mortgage Loans Mortgage Lending Institutions

McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Chapter Review The Roles Played by Leading Financial Institutions in the Mortgage Market -Savings and Loan Associations -Commercial Banks -Life Insurance Companies -Savings Banks -Mortgage Bankers

McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Chapter Review Government Activity in the Mortgage Market -The Impact of the Great Depression on Government Involvement in the Mortgage Market -Launching the Federal Home Loan Bank System -Setting Up the Federal Housing and Veterans Administrations (FHA and VA) -The Creation of Fannie Mae (FNMA) -The Creation of Ginnie Mae (GNMA) -The Federal Home Loan Mortgage Corporation (FHLMC)

McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Chapter Review Innovations in Mortgage Instruments -Fixed-Rate Home Mortgages -Variable-Rate and Adjustable Mortgage Instruments -Convertible Mortgages -Interest-Only Mortgages -Reverse-Annuity Mortgages

McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Chapter Review Pricing and Other Issues in Home Mortgage Lending -Pricing Home Mortgages and the Treasury Security Market -Mortgage Lock-Ins, Loan Modifications, and Foreclosures -Refinancing Home Mortgages -Predatory Lending